Shares digital

Tesco (TSCO) – 448p, stop loss 358p

SHARES SUMMARY

Food price inflation, rapid expansion at home and abroad and the development of new services should enable the retail giant to maintain its excellent trend earnings growth record.

Business:

A leading international retailer

Vital stats:

Market Value: £35,131 million

Historic PE 2006: 20

Prospective PE 2007: 18

Prospective PE 2008: 15.8

Sector PE (next 12 months): 20.8

1-month relative strength: -3.2%

1-year relative strength: +6.0%

Yield 2007: 2.4%

NMS: 50,000

Spread: 0.06%

Despite snowstorms in the Midwest of America, drought is still a major concern for the US winter wheat crop. Wheat prices have remained firm, hovering around 20-year highs at $9.25 per bushel, while soybeans crossed the $11 a bushel threshold last December, a 34-year high. Freak weather in America, Australia and Latin America was undeniably a factor in 2007, but the basic issue is simply that global population growth is outstripping our ability to increase food production. The diversion of crops toward biofuel production, and rising consumer wealth driving higher demand for meat and dairy products in emerging economies such as China, are further aggravating this problem.

Food inflation therefore looks like it is here to stay and, as the UK’s largest supermarket group, Tesco is well placed to capitalise upon this trend. A total of around 2,000 UK stores and around 28 million square feet of retail space means Tesco is big enough and has enough buying power to be able to boost growth by passing on rising costs to its customers, and not take too much of a margin hit itself. Third quarter sales in the UK, unveiled in November’s trading statement, jumped 11.8%, albeit helped by the inclusion of recent acquisition Dobbies Garden Centres.

The chain also offers an exciting international growth story. Tesco already has over 1,300 stores in Eastern Europe, China, Japan and South East Asia and an assault on the USA is now under way. Last November’s analyst trip to visit some of the newly opened ‘Fresh and Easy’ stores garnered favourable comment as well. Tesco has plans to add over seven million square feet of international floor space, and this expansion helped fuel 21.4% sales growth internationally in the third quarter.

The tesco.com, personal finance and telecom services operations are testimony to management’s ability to spot an opportunity and drive additional growth. A new move into IT support for consumers has considerable potential.

An historic trend EPS growth rate in the low double digits should be maintained going forwards, helped by food inflation, international growth and an ongoing share buyback programme. Tesco’s earnings consistency should reward patient investors, particularly if the global credit crunch does lead to a 2008 economic slowdown, which would in turn crimp the earnings power of more cyclical sectors.

Of course, there are risks. Many a British firm has come a cropper in the USA and Tesco could prove to be no exception. Three quarters of income still comes from the UK and if there’s a really steep economic downturn this year, consumers could trade down in food and cut back on some more discretionary items. But even then, people still have to eat and keep their house clean, so Tesco’s earnings are likely to prove more resilient than most.

by: Russ Mould